SECURITIES LAW Settlement by its lead underwriter just a start?

Updated 8:02 pm, Friday, December 21, 2012

News about Facebook stock flashes across the ticker on Morgan Stanley headquarters in May. The bank has settled with Massachusetts regulators.

News about Facebook stock flashes across the ticker on Morgan Stanley headquarters in May. The bank has settled with Massachusetts regulators.

Photo: Mark Lennihan, Associated Press

Morgan Stanley settles Facebook IPO case

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Just as its stock price is experiencing a rebound, Facebook may find itself exposed to legal challenges surrounding its initial public offering similar to those faced by its primary underwriter, Morgan Stanley, legal experts say.

In the first regulatory claims to flow from the May 17 IPO, Massachusetts officials said this week that they fined Morgan Stanley $5 million for letting its investment bankers provide research analysts, specific revenue information that was not disclosed by Facebook to the general public. That broke a decade-old rule enacted after the dot-com crash to block bankers from influencing analysts, regulators said.

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The settlement includes details of the closed-door conversations between Morgan Stanley and Facebook ahead of the IPO, including testimony from Michael Grimes, who led the deal for the bank. According to the consent order, Grimes wrote a script for Facebook's then-treasurer to read to analysts that detailed Facebook's lowered revenue estimates.

Grimes "did everything but make the phone calls himself," the regulator said in a statement.

The revelation that Facebook gave specific estimates to bank analysts and not to the public revives questions about whether the company was sufficiently forthcoming ahead of the IPO, said Stephen Diamond, an associate professor at Santa Clara University School of Law.

"By providing that information to just a subset of potential investors, in essence they have denied other investors access to material information," Diamond said. The Securities and Exchange Commission "should have pushed much harder to find out whether there was quantifiable data available or not," he added.

Facebook has not been accused by regulators of wrongdoing. Michael Buckley, a spokesman for the Menlo Park company, declined to comment. The SEC had no immediate comment. And Morgan Stanley did not admit or deny the claims in settling.

The settlement, though, offers fresh insight into a widely anticipated IPO that turned into a debacle for the company and Morgan Stanley.

Stock price

Facebook shares have rebounded somewhat in recent weeks, but are about 27 percent below where they started trading, at $38, on May 18. The company capitalized on its popularity by raising the price and number of shares sold to retail investors, who weren't privy to the private conversations or revenue estimates.

"The broader issue is the fairness of the marketplace for investors," Galvin said.

The details emerging from the consent order may also add ammunition to dozens of class actions, which a judge has ordered to be consolidated. The testimony disclosed by Massachusetts could be used by prosecutors attempting to make a case that Facebook and Morgan Stanley misled investors, said Erik Gordon, a clinical assistant professor at the University of Michigan's Stephen M. Ross School of Business.

"The real liability for Facebook and Morgan Stanley is yet to come," said Gordon.

If Facebook omitted material facts in its prospectus, known as an S-1, it could be found in violation of Section 11 or 12 of the Securities Act of 1933, Diamond said.

Impact of mobile

While it told potential investors that more people accessing Facebook on mobile devices could adversely affect revenue, it gave a select group of analysts specific numbers on how that trend would affect sales over the full year, which could be considered a material omission, he said.

A violation of Section 11 could result in a fine or injunctive relief, or it could force the company to return proceeds of its IPO to shareholders, Diamond said.

"A material misstatement or omission in an S-1 is the scariest thing in the world," Gordon said. "It's going to hinge on whether the disclosures made in the S-1 were sufficient to give reasonable investors as accurate a view as reasonably possible."

Diamond said the SEC could have been more vigilant as it scrutinized Facebook's IPO prospectus.

The SEC had asked Facebook for more disclosure about the impact of mobile users on revenue during a 2 1/2-month volley of messages, which were published after the IPO on the agency's website. While it succeeded in getting Facebook to reveal more details about its business, it did not ask the company to estimate how mobile use would affect its forecast for lower revenue in 2012, the messages show.

"The SEC bears some responsibility here, too," Diamond said. "That's a question I think Congress ought to ask. Why didn't the SEC wake up and smell that something was going on here?"